CNN Money ran a story about the 10 most popular franchise businesses. The data comes courtesy of the Small Business Administration which offers loans for a number of businesses (but usually for people that can’t get loans elsewhere). While the list isn’t definitive since there are other sources of start-up capital than the SBA, it is an interesting compilation. Because I hate the slideshow format the CNN Money family of websites uses I’ll just tell you the most popular is Subway. Right behind Subway is Quiznos. However only 7% of Subway loans default, whereas Quiznos has a 25% default rate. That’s not just a statement to the popularity of Subway, but also the quality of service franchise owners get from the corporate owner of Subway, Doctor’s Associates Inc.

So how does this franchise stuff work? The companies you normally think of as being at the top of food service, McDonald’s, Subway, KFC, etc aren’t really in the food service industry. They’re in the business of real estate, advertising, and supply chain management. Take McDonald’s for example. Only 15% of their stores are actually operated by the actual corporation. The rest of their revenue comes from franchise fees (which we’ll get to in a second), and rent. McDonald’s may not operate many of their stores, but they do own the locations. They charge rent to the franchisees and without going to their annual report I’d guess they make as much money doing this as they do in the stores they operate.

But McDonald’s is kind of unique with the real estate thing. Most restaurants charge 3 types of fees. There is the franchise fee, advertising fees, and what I call “trailing fees”. The franchise fee is usually an upfront fee you pay to get in the game. It gets you the access to all the wonderful things inside the company such as use of the logo, demographic information on customers, and assistance with getting your shop set up and ready to go. Fees range from a few thousand to the hundreds of thousands depending on the company and type of support you will get in return. They are often sold through brokers as well, so I’d guess there may be negotiating room in there somewhere.

The advertising fee is plain and simple. In most franchises the host company handles the advertising for you. You pay a fee (usually a % of sales) in order to make that happen. The “trailing fees” are what I’d imagine make up the largest portion of the revenue for McDonald’s and other firms like it. These are fees that are paid weekly, monthly, quarterly, or annually as an additional percentage of sales. What’s rough for the franchise owner is that is not a percentage of profits, but sales. Which means McDonald’s can make a profit on your business while you do not. Strategy nerds will note the high level of control the firms are able to exercise over their franchise owners.

This business model is often very confusing to the average person. They assume that McDonald’s owns all their stores. But it really doesn’t matter. You can’t tell the difference between a corporate store and one owned by some local dude. It’s a symbiotic relationship that allows the underlying corporation to grow at levels it could not achieve on its own. It also allows the corporation to offload the risk of expanding onto individual entrepreneurs. This is why so many franchises fail. I’ve watched a Moe’s and a Starbucks leave near me recently, but as a testament to the success of McDonald’s skills in this business I can’t remember the last time I saw an empty McDonald’s.

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  By 		The Weakonomist is the founder of Weakonomics. Clicking the picture of the puppy will tell you more about him. If you like what you're reading consider subscribing to the blog, following him on Twitter, and checking out the related posts below. Please consider a donation if you really enjoy Weakonomics. Also keep in mind that nothing I say can be construed as financial advice.

categories: business